Tom Jones looks at US filing requirements for offshore captives and shows how the regulations of the Internal Revenue Service encourage offshore captives to make annual protective US tax filings.
A US person who is a US shareholder of a foreign corporation that is a controlled foreign corporation (CFC) must file annually Form 5471 (information return of US persons with respect to certain foreign corporations) and attached schedules, with its US federal income tax return, to report its interest in the CFC. A separate copy must also be sent to the Internal Revenue Service Center in Philadelphia, PA.
In general, foreign insurance companies are treated as CFCs if they are more than 25% owned by US shareholders, as defined. Two separate sets of rules apply to determine who is a US shareholder of a CFC engaged in the insurance business.
In the case of foreign insurance companies which do not insure related person risk or which insure a minimal amount of related person risk (less than 20% of their total insurance income), a US shareholder is a US person (corporation, individual, partnership, trust, etc.) owning at least 10% of its voting stock.In the case of an insurance CFC which derives more than 20% of its income from insuring related person risks (i.e., an RPII CFC), a US person is a US shareholder, irrespective of its percentage interest in the RPII CFC.
It should be noted that insurance is a term of art in US tax law requiring the presence of “risk shifting” and “risk distribution”. The ‘normal' (non-insurance) CFC rules would apply to single parent, one “economic family” captives. The Form 5471 filing requirements for a non-insurance company are the same as for a captive which is not an RPII CFC as described above.
The Form 5471 (and related schedules) must contain information relating to the CFC, such as its name, address, date of incorporation and principal place of business. In addition, the form must set forth the earnings and profits (E&P) of the foreign corporation and the amount of the CFC's underwriting and investment income (subpart F) attributable to the particular US shareholder.
Additional information may be required if the US shareholder acquired or disposed of stock in the CFC during the year, the CFC was reorganised or if the US shareholder owns more than 50%.
US tax accounting principles must be used in determining amounts reflected on Form 5471. Most captives use US GAAP, Canadian GAAP or the emerging International Accounting Standards (IAS) for financial accounting purposes. Although the differences among them consist of minor technical or presentation issues, the conversion to US tax accounting standards is more time consuming. A few offshore captive managers have resident US tax specialists on staff who can assist, but in most cases the parent's onshore accountants handle the conversion.
If a US person fails to file Form 5471 or to report all of the information requested, the penalty is $10,000 for each annual accounting period with respect to which the failure exists - which increases to $10,000 per month, up to a total of $50,000, if the failure continues after IRS notice. In addition, the US person may also lose a portion of the foreign income taxes available for credit against US income taxes, but only to the extent that the amount of such credit exceeds the penalty above.
If a US person has a “financial interest” in or signatory authority (orother authority) over any financial accounts, including bank, securities or other types of financial accounts, in a foreign country (even if held at an affiliate of a US bank or financial institution) and the aggregate value of these financial accounts exceeds $10,000 at any time during the calendar year, the US person must file TD F 90-22.1 with the Department of the Treasury to report that relationship. Most offshore captives have one or more such reportable accounts. Form TD F 90-22.1 must be filed on or before 30 June of the year following the calendar year to which it relates.
In general, a US person has a financial interest in a bank, securities or financial account if such person is the owner of record or has legal title to the account, regardless of whether the account is maintained for the benefit of others or for the taxpayer's own benefit. Although the existence of the account must be disclosed, note that the actual transactions involving the account are typically protected from disclosure by stringent bank secrecy laws of the captive's foreign domicile, except for criminal investigations.
The IRS can glean much useful information about offshore captives from these two required filings. But law-abiding captives and theirshareholders, directors and officers should have nothing to fear, and these forms may actually serve to promote a level playing field beneficial to tax compliers.Doing business in the US
Offshore captives are frequently warned not to do business in the United States to avoid a host of negative tax and regulatory consequences. A little known, but very significant provision in the Internal Revenue Code authorises US taxation of a foreign corporation, including an offshore captive, on a gross receipts basis if it mistakenly fails to file a US tax return. An often overlooked procedure exists to avoid this disastrous result.
For many years, Section 882(c)(2) of the code theoretically empowered the IRS to tax a foreign corporation on its gross US business receipts if it failed to file a US tax return, but a later IRS or court determination found that the foreign corporation had engaged in a US trade or business for tax purposes. In the past, many tax experts advised their clients not to file a US tax return unless and until the IRS commenced a tax audit (if ever) alleging that the foreign corporation, indeed, had engaged in a US trade or business. By filing the return late (but before the IRS had made any final determinations), the foreign corporation then, arguably, could have gained the benefit of deductions and credits and thus been taxed on a net income basis.
Tax regulations issued in 1990 preclude the use of this audit lotteryapproach. Treasury Regulation §1.882-4(a) provides a strong incentive for a foreign corporation to make a preemptive US tax filing. Although the foreign corporation may believe its US activities do not constitute a trade or business, by making this filing it will preserve its right to claim deductions and credits, should it prove to be incorrect. Because of the minimal amount of information that needs to be disclosed, and because of the potentially catastrophic impact of being taxed on a gross US receipts basis, serious consideration should be given to making this protective filing with the IRS on an annual basis.
The filing is made on the standard federal income tax return for foreigncorporations, IRS Form 1120F, with a brief explanatory statement attached, disclosing only the foreign corporate taxpayer's name and address. No information regarding income, deductions or credits needs be included. The statement should say only that, because the offshore captive conducts its business activities entirely outside the US, it has determined that it is not engaging in a US trade or business and that the filing is made solely as a precaution to protect its right to be taxed on a net income basis.
These regulations apply to tax years ending after 31 July 1990. For the tax return and statement to be effective, they must be filed not later than 18 months after the due date for the tax return the captive would have filed if it were a US taxpayer. Similar returns and statements should be filed annually thereafter.Some would argue that pointing out to the IRS the very existence of the captive may be a deterrent to making the filing. This drawback, however, may be less onerous than it seems. The US parent of the captive shouldalready be filing IRS Form 5471(as above) annually with respect to its ownership of the captive and the underwriting and investment (subpart F) income generated by its captive. Therefore, submitting this additionalannual filing may not necessarily raise the red flag that triggers a taxaudit.
Two final points merit mention. First, if the captive voluntarily elects to be subject to US tax under Sections 953(c)(3)(C) or 953(d) of the code, then this protective filing apparently need not be made.
Second, many captives have been formed in jurisdictions with which the US has an income tax treaty, such as Bermuda and Barbados. These tax treaties provide no benefit in connection with this protective filing because the regulations specifically impose the same disclosure requirements even if a treaty “permanent establishment” provision applies.
A related but separate issue for tax treaty domiciled captives is a second possible protective filing under Section 6114 of the code dealing with treaty-based return positions. The wording of each treaty and the facts applicable to each captive differ significantly, so careful review of these filing possibilities by an international tax specialist is always prudent.
In summary, most offshore captives already take numerous steps ˜ such asholding all meetings and signing all contracts offshore ˜ to limit their US activities and avoid a US trade or business (for insurance regulatory as well as tax reasons). Nevertheless, given the tremendous tax costassociated with taxation on the basis of the captive's US gross receipts(or at least all its investment income without deductions for even paidclaims), the Section 882(c)(2) tax filing issue is of sufficient importance to be placed on the agenda for discussion at the captive's next offshore board of directors meeting.
Thomas Jones is a partner with the law firm of McDermott, Will & Emery, based in Chicago. He has in-depth experience with the tax and regulatory implications of captives and risk retention groups.